Why Investors Should Avoid Forex.

In the late 1990?s the trading world was introduced to a new world of trading: forex, or currency trading, finally had a retail presence.  For years you could trade forex (FX) only if you were one of the large ‘interbank’ customers.  These mega-banks had long been the sole operators of the highly profitable currency exchanges of the world, but in the late nineties regulatory constraints were eased, allowing Futures Commission Merchants (FCMs) to create what we now understand to be forex trading.

The initial incarnation of these FCMs and this new industry was like the wild west: extreme leverage, low capital requirements for both the trader and the FCM, little regulatory oversight, and as a result, little customer protection.  But what did it matter?  Since retail forex didn’t exist, there were no customers to protect, and the regulatory agencies took a wait-and-see approach.

Not unpredictably, FX grew at a breathtaking pace, and why not – it was (and is) like trader heroin.  Forex trades are fast moving, dynamic swings in price that are impacted by global events that occur 24 hours a day, 7 days a week.  The markets are technically never closed, and the total trading volume in FX dwarfs the trading volume of all of the world’s exchanges combined  It’s a sexy option for a trader!  FX pairs typically move anywhere from 50-150 ‘pips‘  per day, and at the outset a trader could control $100,000 of currency with just $500 in account balance – 200:1 leverage!  That means if you hit the trade in the right direction on a day where the market moved 100 pips in your favor, you made 100 x 10, or $1,000, on your $500 balance.  In a day.

Sounds pretty good, right? Except for one little problem.  Forex is not a market, and it’s not an exchange.  It’s a craps table with loaded dice controlled by the dealer.  And the dealer’s job is literally to extract ALL of the money of the people who come to the table.  Let me explain.

When most people think of trading, they think of the trading markets we all know and love – NYSE, NASDAQ, etc.  These are true exchanges: places where buyers and sellers can meet and execute transactions at prices available to the entire market.  If I want to buy AAPL then I can go to my broker and buy AAPL, and it comes from someone who is selling AAPL at the prevailing market price.  All market participants have (theoretically) equal access to the same prices and liquidity, and it’s the broker’s job (make careful note of the word BROKER) to help you find a trading partner.  They literally provide a match-making service and take a fee (the commission) for doing so.  In this case the broker (assume it’s an ethical broker) has no interest in your trade beyond execution.  They get paid to execute your trade effectively, and that’s it.

There are no Forex Brokers.  They are Dealers.  FX Dealers do not participate in exchanges or access the same prices and liquidity. They maintain their own price feeds, liquidity rules, and trading operations.  They are complete stand-alone markets (in truth, these are sales and marketing companies with regulatory oversight, nothing more).  Still, an FX Dealer could run an ethical business.

Here’s what that would look like:

You want to buy EURUSD at 135.46.  The dealer offers it at the price of 135.46/48, a spread of 2 pips.  Now since this is not an exchange, there is not necessarily a trading partner needed for you to make the trade; it can be a single party transaction just like someone playing craps alone at the table in the casino (I would guess this is true of 99.999% of FX trades).  Since there is no other party, and the dealer is paid a spread to execute your trade, then THEY must take the other side of your position.  If you buy, they sell, if you sell, they buy.  Now if this dealer was an ethical dealer, they would have built risk management systems that aggregated all of their net exposure in a currency and hedged it with their mega-bank trading backer, meaning if 1,000 people went long and short EURUSD and the net exposure was 590 contracts long, the dealer would call someone like Credit Suisse and sell 590 contracts as a hedge.  Then the dealer would have a perfectly hedged trading portfolio at all times; their net revenue would be the total of their spreads less the cost to hedge the positions.

But what if 96% of all traders lost money, and the 4% who didn’t were easy to identify?  An ethical dealer would do nothing differently, but someone who is running a financial sales and marketing business at the most financially corrupt time in history might take different actions.  They might not hedge your trade. In that case, when you bought 1 contract of EURUSD at 135.46, you’d make (and the dealer would lose) $1,000 if the price moved up to 136.46 or lose (and the dealer would make) $1,000 if the price fell to 134.46.  The dealer is literally trading against you – your losses are their gains, and not just your losses of commission, but your losses of principal.

Hopefully you can see how this story ends.  Forex is not an investment marketplace, it’s a casino.  And there’s nothing wrong with that if you are putting up gambling money to try your hand at FX trading.  But it’s NOT INVESTING.  In fact, I would go so far as to say that this is unsuitable for 99% of the investors out there.  If you’re not comfortable with losing your entire account balance, don’t trade FX.  The market dynamics and the very structure of this industry are such that the deck is severely stacked against the normal trader.  And if they tell you it’s a No Dealing Desk operation, that just means they’ve automated it.

Trader Beware!